Global Problems Threaten Fragile U.S. Recovery

The U.S. economy is already facing some pretty heavy headwinds, including the near-term threat of a slowing recovery and the long-term burden of government debt.

Now, slowing global growth looms as well. It will shave at least 0.2 percentage points off U.S. growth in 2011 and twice that much if Europe goes off the rails. Though a U.S. recession is still the weaker bet, the combination of domestic woes plus slower emerging-market growth and European troubles threatens something close to the perfect storm.

In Europe, the debt menace is growing. For now, bond buying by the EU central bank is containing interest rates for the sovereign debt of Italy and Spain — the latest, and so far the largest, victims of Europe’s fiscal flu. Worries about contagion are dampening growth in Germany, an economy driven by exports to its euro zone neighbors. They’re also pushing France to tackle its fiscal flab by trying to quickly trim public spending to avert a crisis.

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Legitimate anxiety about bank write-downs will continue to rattle stock markets, both in Europe and the U.S. Worry about the need for more bailouts is also on the rise, fueling anti-euro sentiment among European nations. EU officials say they’re committed to the currency, but investors fret about the cost of saving it if Italy or Spain needs a bailout.

At the same time, superfast growth in emerging markets is moderating. Some countries are tapping the brakes in a calculated effort to temper inflation and dampen speculation in real estate and other assets. In China, for example, where inflation hit 6.5% (annualized) in July, officials have upped the minimum requirements for bank reserves 12 times since 2010. Similarly, South Korea tightened rules on stock trading and raised interest rates earlier this year. And in April, Brazil imposed a 3% tax on bank lending.

Governments are also cinching in public spending, hewing to budgets that are more austere. Brazil intends to trim $32 billion from its government spending — about 5%. India aims to cut its budget deficit to 4.6% of its GDP, which is less than half the expected U.S. rate. The lackluster U.S. and European economies will also sap demand for imports, cutting into emerging economies’ foreign sales. In July, factory growth in China, for example, contracted for the first time in a year.

A slowdown in emerging economies is particularly critical, because those nations have been the engine of global gains since the 2008 financial crisis laid low the world’s richer nations. Developing countries will provide about two–fifths of the upward impetus in 2011. In contrast, that group accounted for just one-fifth of world growth a generation ago.

Figure overall world economic growth will slow to about 3.8% this year — down from 5% last year and half a percentage point lower than expected earlier in 2011. That relaxed pace will bite into American exports. Based on the U.S. share of global exports, the slowdown means a loss of about $27 billion from GDP this year. With only a 2% gain in U.S. GDP likely, the loss of that output will be felt.

Still, barring yet another storm, we continue to expect the U.S. to avoid recession.